How Blockchain Technology Can Improve Inefficiencies in Capital Markets

For financial institutions in today’s economy, success is heavily determined by the ability of entities to innovate based on market trends, client necessities, and above all, prevailing digital platforms. The capital markets industry currently finds itself in a compromising position; does it adapt to new digital trends and technology, or does it deter against ‘risky’ change and remain stagnant – but comfortable – in its pervious ways? A controversial, yet powerful, technology that has been become prominent in the recent years is Distributed Ledger Technology (DLT); otherwise known as blockchain.

Digitization is becoming prevalent across financial services; and for capital markets – an industry based on quickly evolving data – it is crucial for firms to embrace innovative change. As new technologies, like blockchain, are quickly emerging and being widely explored, the market is heading in an increasingly inevitable direction; and firms that fail to see this, or reject the potential added value of these technologies, may face the consequences of other participants’ first mover’s advantage.

In the last 20 years most of the technology improvements in capital markets have been concentrated in front office operations while middle and back-office functions continue to face persisting issues. More specifically, KYC/AML and post-trade settlement processes remain relatively inefficient. Additionally, there are people with limited access to the markets due to cost barriers, effectively eroding the market base, investment, and most importantly, liquidity. Blockchain can provision capabilities to capital market operations that would greatly benefit financial institutions and their clients.

The development of blockchain technology in capital markets is still in the early stages of adoption; but it is now more important than ever for firms to become involved. The era of digitalization has resulted in sweeping changes in the industry mindset.

In 2018, 90% of European and North American banks were exploring blockchain technology._. Now, with many different initiatives, this trend continues.

Although the last decade has seen pre-trade and trade execution processes improve, the clearing and settlement of these exchanges – i.e., the post-trade process – remains a lengthy one. While assets can be traded electronically in micro-seconds, it still can take 3 days for reconciliation of the transaction to be settled.

Financial institutions currently allocate substantial resources to ‘Know Your Client’ (KYC) and ‘Anti-Money Laundering Laws’ (AML) compliance programs, spending between $60 million to $500 million annually. In addition to the labor-intensive nature of these current compliance programs, they are quite complex. Failure to abide to regulatory requirements can lead to large fines – from 2008 to 2018 U.S. financial institutions were fined a total of $26 billion. Not only are these processes inefficient, but many firms also face pressure from clients to expedite their onboarding process. All in all, business is being affected – and hurt – at the expense of technological inability; not because the technology isn’t available, but because it hasn’t been adopted.

Financial Institutions not capitalizing on new emerging technologies leave capital markets more susceptible to higher barriers to entry and lower levels of liquidity than would otherwise exist if such institutions adopted these new innovations.

Clearing and settlement services are critical to the financial markets, where DTCC acts as one of the only providers dealing in the post-trade process. Mike Bodson, CEO of the Depository Trust & Clearing Corporation (DTCC), recently described his company as the most important financial institution that only a few people know about. He expresses the criticality of managing risk effectively. Although a party can buy a security today, you’re not going to actually pay for it for three days. So, inherently, within that time span, there is risk; and they help handle that. It is this risk, exactly, that would be eradicated with blockchain technology; and Bodson himself is aware of that, as the DTCC is in the process of rewriting their trade information warehouse into distributed ledger using smart contracts.

Instead of having intermediaries, such as DTCC, absorb the default risk when a transaction is made, and taking the responsibility for settling the exchange, the use of ‘smart contracts’ with blockchain technologies enables a real-time check on the availability of trade instruments. Due to the regulatory changes that generally follow new technologies in the market, the DTCC and other central depositories will likely remain, but in a more hybrid format; i.e., use DLT for their data/trade information, and oversee the settlement process with minimal functional influence. Reconciliation has generally been a time-consuming and labor-intensive process, involving the gathering of information on different ledgers and storing data in different formats. Blockchain technology allows information to be shared across participants of a transaction in a common configuration.

Current KYC and AML processes are manual, fragmented, and slow. The requirements that all financial institutions must meet differ by entity – there is no global standard. At present, the verification for clients in one institution cannot be automatically duplicated to another institution; and sometimes the entities are under the same company. There is a need for a more streamlined process; and one that saves both the client, and the business, valuable time.

Because of the way information is shared on a distributed ledger system, information is more secure, immutable, and transparent, as ‘nodes’ on blockchain are aware of any personal information that is visible. A customer’s background, financial records, income sources, etc. can be placed on the blockchain once there is a consensus that the information is valid; and for that reason, it is more difficult for false information to be submitted than current methods. Costs for financial institutions to undertake the required KYC/AML activities would be reduced substantially, and cross-institution client verification can catalyze resources to be allocated for productivity purposes, and not compliance based.

Asset tokenization refers to a process of creating decentralized, digital ownership of assets which can later be traded. This fractional ownership might include stakes in hard assets such as real estate, automobiles, and paintings or less tangible assets like stock/bond securities. Typically, tokens are issued on a blockchain platform, such as Ethereum, which can accommodate the securitization process and ensure its immutability and record of ownership. As asset tokenization sweeps across industries traditionally too cumbersome to trade, the broader financial services sector has investigated the practice to bolster its position relative to innovative fintech firms.

By adopting asset tokenization capabilities, financial services firms can facilitate transactions more quickly and at cheaper cost with the automation of smart contracts. Additionally, asset tokenization is appealing for banks and investment managers due to its increasingly high divisibility. As it makes the investment process more accessible and liquid, firms stand to benefit from the inclusion of non-traditional investors or investors with lower account minimums.

The benefits of blockchain technology are evident; but, like any new technology in the financial industry – with regard to implementation – there will be concerns.